BALANCE SHEET STRUC7URWE AND MANAGEMENT
4.2 Asset Structure: Growth and Changes
Assets. The banking sector's assets comprise items that are a reflection of individual banks' balance sheets, although the structure of balance sheets
TABLE 4.1 A BANK'S BALANCE SHEET STRUCTURE
Period Period Period Current
Assets as percentage of total assets 1 2 3 Period
Cash and balances with the central bank 0.73 2.64 6.82 3.37
Investment securities - stable liquidity portfolio 0.32 8.20 15.87 12.61 Proprietary trading securities at market value 0.56 7.33 6.35 4.48 Placements with banks and credit institutions 39.14 27.20 20.21 9.28
Loans and advances to customers 58.06 52.38 45.62 63.28
Other investments - subsidiaries, etc. 0.00 0.00 0.00 0.00
Fixed assets net of depreciation 1.19 2.21 5.11 6.96
Other assets 0.00 0.03 0.02 0.02
Total 100.00 100.00 100.00 100.00
Liabilities as percentage of total liabilities and capital
Due to other banks and credit institutions 40.45 34.40 40.35 44.12 Funding for the trading portfolio (investment
portfolio) - repurchased securities 2.05 3.78 3.25 2.45
Due to other customers/depositors 42.84 32.29 34.79 25.44
Certificates of deposit 0.64 4.11 4.48 4.23
Other liabilities 0.04 0.59 1.87 4.06
Amounts owed to government institutions 0.04 0.09 0.08 0.03
Due to international lending agencies 0.00 5.35 0.56 3.04
Subordinated debt 0.00 5.35 0.56 3.04
Shareholders' equity 13.94 14.04 14.06 13.58
Total 100.00 100 00 100100 100.00
BALANCE SHEET STRUCTURE AND MANAGEMENT 63
may vary significantly depending on business orientation, market envi- ronment, customer mix, or economic environment. The composition of a bank's balance sheet is normally a result of asset-liability and risk man- agement decisions. Figures 4.2 and 4.3 illustrate the structure and growth of the asset components of a bank over time.
The analyst should be able to assess the risk profile of the bank simply by analyzing the relative share of various asset items and the changes in pro- portionate share over time. For example, if the loan portfolio jumps from 58 percent to 64 percent of on-balance-sheet assets (Figure 4.3), one would question if the bank's credit risk management systems are adequate to enable handling of the increased volume of loan transactions and of the loan portfolio. In addition, such a change would disclose a shift from another risk area. Likewise, an increase or decrease in trading securities would indicate a change in the level of market risk to which the institution is exposed. Such observations are possible prior to a detailed review of either the credit or the market risk management areas. When linked to the amount of net income yielded by each category of assets, this analysis increases in importance, enabling a challenging assessment of risk versus reward.
Overall liquidity of assets. Liquid assets are needed to accommodate expected and unexpected balance sheet fluctuations. In environments where markets are not developed and the liquidity of different claims still depends almost exclusively on their maturity rather than on the ability to sell them, banks tend to keep a relatively high level of liquid assets that bear little or no interest. In such environments, liquid assets typically account for at least 10 percent, or in extreme situations as much as 20 per- cent, of total assets. Increasing market orientation, the growth of financial markets, and the greater diversity of financial instruments worldwide entails greater short-term flexibility in liquidity management, which in turn reduces the need to hold large amounts of liquid assets. In banking envi- ronments with developed financial markets, liquid assets typically account for only about 5 percent of total assets. An appraisal of whether the level of liquid assets is satisfactory must be based on a thorough understanding of money market dynamics in the respective country, as certain assets that
appear liquid in good times may not be liquid in more difficult periods.
Cash and balances with the central bank represent the holdings of highly liquid assets, such as bank notes, gold coin, and bullion, as well as
FIGURE 4.2 STRUCTURAL CHANGE AND ASSETS GROWTH 4,000,000
3,500,000 3,000,000
2,500,000 ...
2,000,000 1,50000000000
1,000,000
... ...
500,000mn
Period 1 Period 2 Period 3 Period 4 Current Period El Loans and advances to customers E Trading securities at market value E3 Placements with banks and credit institutions ID Cash and balances with the central bank f Investment securities 13 Fixed assets net of depreciation E Other assets
FIGURE 4.3 CHANGES IN THE STRUCTURE OF A BANK'S ASSETS PORTFOLIO Current Period Assets Prior Period Assets
3% 7% 7%
41 .5% OIIII3- 5 j. oooooo
000 ::: ooooooo __ ---ooooooo
00000000 13 oooooooooooo
_ ooooOt13%g ~%--300000000oo°oo°oo°oo°o0
C.~~~~~~~~~~~~~~~~
: | / < .,,.2 <<; ,J ,. ll il l l 1 0, ., -' 'h '': C C.'.w ' 58%
m Loans and advances to customers E[l Placements with banks and credit institutions ED Investment securities E Trading securities
* Cash and balances with the central bank M Fixed assets net of depreciation
E Other assets
BALANCE SHEET STRUCTURE AND MANAGEMENT 65
deposits with the central bank. A percentage of deposits is normally required to be held in order to meet the central bank's reserve require- ments and serve as a monetary policy tool. Flat-rate reserve requirements are used to control the amount of money that a bank is able to extend as credit. However, when banks are required to hold excessive reserve assets, particularly when the assets do not pay interest, the cost to banks increases. This creates incentives for banks to devise instruments that are not subject to reserve requirements, encourages intermediation through new channels, and may give a competitive advantage to institutions that are not subject to reserve requirements. Such practices tend to reduce the effectiveness and the importance of.reserve requirements as a monetary policy tool.
Regulators have tried to make reserve requirements more difficult to circumvent, and to reduce the incentives for doing so. For example, changes in reserve requirements that have been introduced by regulators include a reduction of the level, type, and volatility of reserve holdings, and/or an increase in the various types of compensation made to banks for maintaining reserves.
Stable liquidity/investment and trading portfolios. These assets represent the bank's investment and proprietary trading books in securi- ties, foreign currencies, equities, and commodities.
Although similar securities are involved, the investment portfolio (Chapter 10) must be distinguished'from the proprietary trading portfolio (discussed in Chapter 11). Proprietary trading is aimed at exploiting mar- ket opportunities with leveraged funding (for example, through the use of repurchase agreements), whereas the investment portfolio is held and trad- ed as a buffer/stable liquidity portfolio.
Investment and trading assets are valued in terms of IAS 39 and can be classified as "trading, available-for-sale, or held-to-maturity." However, these assets would normally be disclosed at fair value (marked-to-market) in the bank's financial statements (see Chapter 5.2 for the treatment of income on such assets and Chapter 14 for IAS disclosure).
In many developing countries, banks have been or are obligated to purchase government bonds or other designated claims, usually to ensure that a minimum amount of high-quality liquidity is available to meet deposit demands. Frequently, the main purpose of such liquid asset
requirements is to ensure a predictable flow of finance to designated recipients. Government is the most frequent beneficiary, often with an implicit subsidy. Such obligatory investments may diminish the avail- ability and increase the cost of credit extended to the economy (and the private sector), and due to the increased cost of credit result in a higher level of risk.
In developed countries and financial markets, an increase in bank investment and trading portfolios generally reflects the growing orienta- tion of a bank to nontraditional operations. In such cases, an investment portfolio comprises different types of securities instruments. In risk man- agement terms, such an orientation would mean that a bank has replaced credit risk with market and counterparty risk.
Loans and advances to customers are normally the most significant component of a bank's assets. These include loans for general working capital (overdrafts), investment lending, asset-backed installment and mortgage loans, financing of debtors (accounts receivable and credit card accounts), and tradable debt such as acceptances and commercial paper.
Loans and advances are extended in domestic and foreign currency and are provided by banks as financing for public or private sector invest- ments.
In the past decade, innovation has increased the marketability of bank assets through the introduction of sales of assets such as mortgages, auto- mobile loans, and export credits used as backing for marketable securities (a practice known as securitization and prevalent in the United States and the United Kingdom).
An analysis of this trend may highlight investment or spending activi- ty in various sectors of the economy, while an analysis of a foreign curren- cy loan portfolio may indicate expectations regarding exchange rate and interest rate developments. Further, evaluation of trade credits may reveal important trends in competitiveness of the economy and its terms of trade.
Other investments could comprise a bank's longer-term equity-type investments, such as equities and recapitalization/ non-trading bonds held in the bank's long-term investment portfolio - this includes equity investments in subsidiaries, associates, and other listed and unlisted enti- ties. The percentage of a portfolio that is devoted to this type of instrument varies among countries, though not necessarily as a result of a bank's own
BALANCE SHEET STRUCTURE AND MANAGEMENT 67
asset-liability management decisions. Such assets are also valued in terms of IAS 39 and will normally be classified as "available-for-sale, or held- to-maturity."
For equity investments, the balance sheet should be reviewed on a consolidated basis to ensure a proper understanding of the effect of such investments on the structure of the bank's own balance sheet, and to prop- erly assess the asset quality of the bank.
]Fixedl assets represent the bank's infrastructure resources and typi- cally include the bank's premises, other fixed property, computer equip- ment, vehicles, furniture, and fixtures. In certain circumstances, banks may have a relatively high proportion of fixed assets, such as houses, land, or conmmercial space. These holdings would be the result of collections on collateral which, under most regulations, banks are required to dispose of within a set period of time. They may also reflect the deliberate decision of a bank to invest in real estate, if the market is fairly liquid and prices are increasing. In some developing countries, investments in fixed assets reach such high proportions that central banks may begin to feel obliged to limit or otherwise regulate property-related assets. A bank should not be in the business of investing in real estate assets, and therefore a prepon- derance of these assets would affect the assessment of the bank. In more developed countries, real estate assets not acquired in the normal course of banking business would be booked in a subsidiary at the holding com- pany level in order to protect depositors from associated risks.
Other assets often include intangible assets. These vary with regard to the predictability of income associated with a particular asset, the exis- tence of markets for such assets, the possibility of selling the assets, and the reliability of the assessments of the asset's useful life. The treatment of assets in evaluating capital adequacy can be controversial. For exam- ple, assets may include suspense accounts, which have to be analyzed and verified to ensure that the asset is indeed real and recoverable.
4.3 Liabiigtes Structure. Girowth and Changes
As explained in Section 4.2, the relative share of various balance sheet components - liabilities, in this instance - is already a good indication of the risk levels and types of risk to which a bank is exposed.
An increase in the level of nonretail deposits funding, such as repur- chase agreements or certificates of deposit, could expose the bank to greater volatility in satisfying its funding requirements, requiring increas- ingly sophisticated liquidity risk management. Funding instruments such as repurchase agreements also expose a bank to market risk, in addition to liquidity risk.
Liabilities. The business of banking is traditionally based on the con- cept of low margins and high leverage. Consequently, a special feature of a bank's balance sheet is its low capital-to-liabilities ratio, which would normally be unacceptable to any other business outside the financial ser- vices industry. The acceptable level of risk associated with such a struc- ture is measured and prescribed according to risk-based capital require- ments, which are in turn linked to the composition of a bank's assets.
While the types of liabilities present in a bank's balance sheet are near- ly universal, their exact composition varies greatly depending on a particular bank's business and market orientation, as well as by the prices and supply characteristics of different types of liabilities at any given point in time. The funding structure of a bank directly impacts its cost of operation and there- fore determines a bank's profit potential and risk level. The structure of a bank's liabilities also reflects the specific asset-liability and risk management policies of a bank. Figure 4.4 illustrates a typical liability structure.
Interbank funding comprises amounts due to other banks and credit institutions. It includes all deposits, loans, and advances that are extended between banks and are normally regarded as volatile sources of funding.
An analysis of interbank balances may point to structural peculiarities in the banking system; for example, when funding for a group of banks is provided by one of its members.
International borrowing may occur in the same form as domestic funding, except that it normally exposes a bank to additional currency risk. Direct forms of international borrowing include loans from foreign banks, export promotion agencies in various countries, or international lending agencies, as well as vostro accounts. Indirect forms include notes, acceptances, import drafts, and trade bills sold with the bank's endorse- ment; guarantees; and notes or trade bills rediscounted with central banks in various countries. The existence of foreign funding is generally a good indicator of international confidence in a country and its economy.
BALANCE SHEET STRUCTURE AND MANAGEMENT 69
FIGURE 4.4 STRUCTURAL CHANGE AND GROWTH OF CAPITAL AND LIABILITIES Currency
4,000,000 --
3,500,000 -_
3,000,000- -- 2,500,000 -- 2,000,000 -1 - 1,500,000- -
iiiiiiii 1,000,000 -_
500,000-.
Period 1 Period 2 Period 3 Period 4 Current Period El1 Capital 0 Repurchased securities
E Subordinated debt E Certificates of deposit
* Due to government institutions El Due to international lending agencies
* Other liabilities rJ Due to other customers/depositors
= Due to banks and credit institutions
Given the volatility of such funding sources, however, if a bank is an extensive borrower its activities should be analyzed in relation to any other aspects of its operations that influence borrowing. The acceptable reasons for reliance on interbank funding include temporary or seasonal loan or cash requirements and the matching of large and unanticipated withdrawals of customer deposits. Money centers or large regional banks engaged in money market transactions tend to borrow on a continuous basis. Otherwise, heavy reliance on interbank funding indicates that a bank carries a high degree of funding risk and is overextended in relation to its normal deposit volume.
Repurchase agreements (to enhance returns on proprietary trad- ing). Instead of resorting to direct borrowing, a bank may sell and simul-
taneously agree to repurchase securities at a specific time or after certain conditions have been met. Repurchase structures are often used to fund a bank's trading portfolio and to enhance returns on such portfolios.
The proprietary trading portfolio is therefore aimed at exploiting mar- ket opportunities with leveraged funding such as repurchase agreements, whereas the investment portfolio is held and traded as a buffer/stable liq- uidity portfolio - and funded with more stable deposits.
Repurchase agreements may expose banks to interest rate or market risks as they involve underlying securities, and even a credit risk if the buyer is unable to follow through on its commitments. The level of secu- rities sold under repurchase agreements has (in the past) also served as a barometer of the level of disintermediation in the system, as well as the demand for wholesale funds.
Deposits usually constitute the largest proportion of a bank's total lia- bilities. Deposits from customers - the amount due to other customers and depositors - represent money accepted from the general public, such as demand and savings, fixed and notice, and foreign currency deposits.
The structure and stability of the deposit base is of utmost importance.
Broader trends also come into play. An analysis of private sector deposits (including funding from repurchase agreements and certificates of deposit) highlight economic trends related to the level of spending, as well as its effect on inflation. Furthermore, growth in money supply is calcu- lated using total deposits in the banking system. A change in the level of deposits in the banking system is therefore one of the variables that influ- ences monetary policy.
Within the deposit structure, some items are inherently more risky than others. For example, large corporate deposits are less stable than household deposits, not only because of their higher degree of concentra- tion but also because they are more actively managed. A large proportion of nonretail or nonstandard deposits can be unstable, and tends to indicate that the bank may be paying higher rates of interest than its competitors or that depositors may be attracted by liberal credit accommodations. Cash collateral and various types of loan escrow accounts may also be counted as deposits, although these funds can only be used for their stated purpose.
Competition for funds is a normal part of any banking market, and depositors, both households and corporations, often aim to minimize idle
BALANCE SHEET STRUCTURE AND MANAGEMENT 71
funds. A bank should therefore have a policy on deposit attraction and maintenance and procedures for analyzing, on a regular basis, the volatil- ity and the character of the deposit structure so that funds can be produc- tively utilized even when the probability of withdrawal exists. Analysis of the deposit structure should determine the percentage of hard-core, stable, seasonal, and volatile deposits.
IBorrowings from the central bank may also appear among the bank's liabilities. The most frequent reason for borrowing from the central bank is that changes have occurred in the volume of required reserves as a result of fluctuations in deposits. These shifts occur when banks have not correctly forecasted their daily reserve position and have been forced to borrow to make up the difference, or to assist banks to meet temporary requirements for funds. Longer-term credit from the central bank indicates an unusual situation that may be the result of national or regional difficul- ties or problems related to the particular bank in question. Historically, central bank financing was often directed toward a special purpose deter- mined by government policies, for example, in the areas of agriculture or housing, but this type of activity is increasingly out of date.
The capital of a bank represents the buffer available to protect cred- itors against losses that may be incurred by managing risks imprudently.
According to international norms, banks normally have three tiers of cap- ital components (see Chapter 6 for further discussion). The key compo- nents of bank capital are common stock, retained earnings, and perpetu- al preferred stock, all of which are counted as Tier 1 capital. Otherwise, to qualify for Tier 1 or Tier 2 capital, a capital instrument should have long maturity and not contain or be covered by any covenants, terms, or restrictions that are inconsistent with sound banking. For example, instru- ments that result in higher dividends or interest payments when a bank's financial condition deteriorates cannot be accepted as part of capital. Tier 2 and Tier 3 capital components will often mature at some point, and a bank must be prepared to replace or redeem them without impairing its capital adequacy. When determining capital adequacy, the remaining maturity of Tier 2 and Tier 3 capital components should therefore also be assessed.
Off-balance-sheet iterns. Financial innovation has also led to a vari- ety of new "off-balance-sheet" financial instruments. The costs associated